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Principal Issues: [TaxInterpretations translation] What is the tax treatment of an amount paid by a taxpayer in respect of a swap transaction entered into to protect the value of credit extended to the taxpayer?
Position: The transaction is a hedging operation. The amount paid is a capital expenditure.
Reasons: In the situation analyzed, the sum was to be paid in order to allow the SWAP contract to be surrendered.
July 29, 2004
XXXXXXXXXX Tax Services Office Headquarters
Financial Industries Division
Attention: XXXXXXXXXX
Michelle Desrosiers
Notary, M.Fisc.2003-002376
Loss on a hedging transaction
This is further to your letter of May 21, 2003 in which you asked us to determine the tax treatment of an amount paid by a taxpayer in respect of a swap transaction entered into as part of a monetization transaction.
Unless otherwise indicated, all statutory references herein are to provisions of the Act.
The facts as we understand them are as follows:
1. XXXXXXXXXX (the "Taxpayer") held XXXXXXXXXX common shares of XXXXXXXXXX ("Corporation1").
2. On XXXXXXXXXX, the Taxpayer transferred, pursuant to subsection 85(1), all of its shares of Corporation1 to XXXXXXXXXX ("Corporation2 "). In consideration for the disposition of the shares, the Taxpayer received, inter alia, XXXXXXXXXX common shares of Corporation2.
3. On XXXXXXXXXX , the Taxpayer entered into a financial swap transaction ("Swap") with XXXXXXXXXX (the "Financial Institution"). In this respect, the Master Agreement (the "Master Agreement"), the confirmation letter for the Master Agreement (the "Confirmation Letter") and the Annex to the Confirmation Letter (the "Annex") were analyzed. The Master Agreement has the function of laying down the guidelines of the Swap contract between the parties while the Annex adapts the Master Agreement by amendments according to the needs of the parties and the jurisdiction of the contract. It is the Confirmation Letter that governs the agreement between the parties.
4. The Master Agreement is governed by XXXXXXXXXX. It provides in paragraph XXXXXXXXXX that the parties undertake to make the payments agreed to in the Confirmation Letter. The Master Agreement is for the payment of a sum of money determined by the ceiling and floor values determined by the parties on a specific security, in this case the shares of the Corporation2.
5. The Swap was based on XXXXXXXXXX Corporation 2 shares and the following values were set:
Floor value $XXXXXXXXXX per share
Ceiling value $XXXXXXXXXX per share
6. The Swap had a term of XXXXXXXXXX years and ended on XXXXXXXXXX. Under the terms of the Swap, the Taxpayer was obliged to make a payment to the Financial Institution if the market value of the shares at maturity was higher than the ceiling value. If the market value of the shares at maturity was lower than the floor value, the Financial Institution would instead have the obligation to make a payment to the Taxpayer. On the payment by either party according to the value of the shares at that time, account had to be taken of the sums owed, if any, by the Taxpayer following the receipt of a loan on the same date as the Swap contract. Thus, it is stated in the clause entitled "XXXXXXXXXX" in the Confirmation Letter, that in the event that the Financial Institution would have to pay the Taxpayer at the end of the Swap, it would take into account the amounts due by the Taxpayer before making such payment. Thus, it would offset the amounts due on both sides. The loan transaction will be described in more detail later.
7. Clause XXXXXXXXXX of the Confirmation Letter entitled "XXXXXXXXXX" refers to the guarantee agreement called "XXXXXXXXXX", granted by the Taxpayer to the Financial Institution on XXXXXXXXXX as well as to the ability of the Financial Institution to offset its contingent liability against the Taxpayer's liability arising from the loan from the Financial Institution. The XXXXXXXXXX parts of the Annex also refer to the loan and/or guarantee agreements between the parties. Furthermore, Article XXXXXXXXXX reads as follows:
" XXXXXXXXXX ".
Among those obligations, the Taxpayer undertook not to sell, transfer or otherwise dispose of the shares pledged as collateral under the terms of the "XXXXXXXXXX". Those shares are the ones on which the parties based the Swap.
8. On XXXXXXXXXX , the Taxpayer borrowed from the Financial Institution an amount of $XXXXXXXXXX. For the current purposes, the following contracts were analyzed: the "XXXXXXXXXX" in which the amount of money loaned to the Taxpayer is confirmed, the "XXXXXXXXXX" which sets out the guarantees provided to the Financial Institution and the "XXXXXXXXXX" which is the loan contract itself. The latter contract includes an annex entitled "XXXXXXXXXX" in which the main data for the loan are recorded. The loan contract includes, inter alia, the following provisions:
XXXXXXXXXX.
The "XXXXXXXXXX" referred to in the loan agreement is the Master Agreement.
9. The "XXXXXXXXXX of the loan agreement provides for the following:
Date of the contract: XXXXXXXXXX;
Borrower: the Taxpayer;
Lender: the Financial Institution;
Maturity: XXXXXXXXXX;
Amount granted: $XXXXXXXXXX.
This amount corresponds to the floor amount provided for in the Master Agreement multiplied by the number of Corporation2 shares pledged as collateral in the "XXXXXXXXXX".
10. In XXXXXXXXXX , Corporation2 carried out a stock split of XXXXXXXXXX shares for 1 share.
11. In XXXXXXXXXX, in a takeover, XXXXXXXXXX acquired all the shares of Corporation2 , including those held by the Taxpayer, for $XXXXXXXXXX per share. This event terminated the Swap and the loan. Indeed, the Swap provided that it would terminate on the occurrence of extraordinary events. The loan agreement also provided for the termination of the loan in the same situations as those provided for in the main agreement.
12. Under the Swap, the Taxpayer was required to pay an amount of $XXXXXXXXXX to the Financial Institution, as calculated below:
Share value (price received) $XXXXXXXXXX
Ceiling value (after split XXXXXXXXXX) XXXXXXXXXX
Difference $XXXXXXXXXX
X
Number of shares (after split XXXXXXXXXX) XXXXXXXXXX
Payment $XXXXXXXXXX
13. The Taxpayer reported a capital gain on the disposition of all of the Taxpayer’s shares of Corporation2 and claimed a business loss for the payment made to the Financial Institution.
Your Question
Is the tax treatment applied by the Taxpayer on the amount paid to the Financial Institution appropriate in the circumstances?
Your Position
You argue that the Swap contract is a hedging transaction and that there is a direct link between this contract and the shares of Corporation2. The payment made by the Taxpayer to the Financial Institution should be treated as capital. In support of this finding, you refer to the passage from the Supreme Court of Canada decision in Shell Canada Ltd. v. The Queen, 99 DTC 5682 ("Shell"), which states that the courts must consider the economic reality underlying the transaction and not feel bound by its apparent legal form.
In this case, the financial instrument allowed the Taxpayer to retain ownership of the securities and to benefit from any dividend income on the shares during the period when this arrangement was effective.
In support of the existence of a link between the hedge and the holding of the shares, you referred us to the clause in the agreement specifying extraordinary events and their effects. It states that the agreement ends when there is a takeover and the shares are transferred.
Also, according to Shell, whether a hedge qualifies for income or a capital gain treatment depends on the characterization of the debt (or asset) to which the hedge relates. Since the gain on the disposition of the Corporation2 shares is considered to be a capital gain, then the holding of the Corporation2 shares was not associated with an adventure or concern in the nature of trade. Consequently, the hedging transaction relating to those assets must be qualified as a capital transaction. This is evident from the Taxpayer's intention when signing the main agreement, which was not to dispose of its shares before the expiry of the Swap.
The objective of the hedging agreement was to limit the risk of fluctuations in Corporation2's share price while preserving capital.
The Taxpayer's Position
The transaction is speculative in nature as it is stated in paragraph XXXXXXXXXX of the Confirmation Letter that: "XXXXXXXXXX." Under the Swap contract, the Taxpayer had the chance of making a gain or ran the risk of making a loss, as was the case here. If a gain had been made, it would have constituted business income. It therefore follows that the transaction was an adventure in the nature of trade.
The Taxpayer had no obligation to sell the shares under the agreement. The Taxpayer’s only obligation under the agreement was to make the scheduled payment based on the market value of the securities at maturity and the ceiling value. If the fair market value of the securities at maturity had been less than the floor value, then the Financial Institution would have had an obligation to make a payment to the Taxpayer.
The transaction was therefore in no way related to the eventual disposition of the shares of Corporation2. Also, the Taxpayer had no intention of selling those shares upon expiry of the Swap contract. It was only after the offer to purchase was made in XXXXXXXXXX that the decision to sell the shares of Corporation2 was taken. Thus, the sale of the Corporation2 shares and the payment to the Financial Institution were entirely independent.
Therefore, the nature of the gain realized on the disposition of the shares of Corporation2 shares had no impact on the nature of the loss sustained as a result of the obligations assumed by the Taxpayer under the Swap contract.
Jurisprudential principles confirm that since derivatives are by nature speculative instruments, they are held in the course of an adventure in the nature of trade. The corollary to this conclusion is that the appropriate tax treatment is to then treat the gains and losses as business income or loss.
The Canada Revenue Agency ("the Agency") has expressed its position on the appropriate tax treatment of amounts received under a Swap to the effect that the acquisition of a Swap constitutes a stand-alone transaction whose tax treatment is not linked to the underlying primary obligation. Although there is a direct link between the loan that is the primary obligation, and the Swap that is the secondary obligation, the Agency concluded that the nature of the primary obligation is irrelevant in determining the appropriate tax treatment of payments made under a Swap contract. The Agency considered that the Swap was in itself a speculative act and as such constituted an adventure in the nature of trade. This position was reiterated after the Shell decision.
It is true that the courts must take into account the economic reality underlying the transaction and not consider themselves bound by its apparent legal form. However, the Supreme Court in Shell added that in the absence of an express provision to the contrary in the Act or a finding that the transaction in question is a sham, the legal relationships established by the Taxpayer must be respected in tax matters.
The Agency must therefore treat the transaction in dispute as a Swap. Furthermore, contrary to the facts of Shell, the Swap and the sale of the shares were not two interdependent transactions since one could have taken place without the other.
First, it is important to clarify two points. The Agency has never expressed a position on the tax treatment of equity swaps. The tax treatment referred to by the Taxpayer in its submissions applies to an interest Swap. Second, the Agency applies the principle identified by the Supreme Court of Canada in Shell that, in the absence of an express provision to the contrary in the Act or a finding that the transaction at issue is a sham, the true legal relationships established by the Taxpayer must be respected for tax purposes. Recharacterization is only possible when the Taxpayer's designation of the transaction does not adequately reflect its true legal effects.
We are of the view that the swap transaction entered into by the Taxpayer constitutes a genuine Swap. However, we believe that this transaction must be analyzed in its context. Thus, before embarking on the analysis of the tax treatment of the Swap, viewed as such, concluded between the Taxpayer and the Financial Institution, we believe it is appropriate to specify that the Swap is part of a set of transactions commonly referred to as monetization.
Monetization is a financial transaction that makes the value of an asset (e.g. shares in a public corporation) liquid while protecting from the fluctuating value of that asset. It allows a shareholder to diversify its investment portfolio. Monetization is therefore an alternative to the outright sale of the security without causing its tax disposition. It involves two distinct transactions. The first transaction consists of hedging the risk of fluctuation in the value of the security in question by using a derivative product, in this case a Swap. The second transaction consists of using the shares and the derivative for financing by taking out a loan. In order to receive the loan, the shareholder grants a security interest in the monetized shares as well as in all of its rights and obligations under the hedging contract.
Briefly, a Swap agreement is a private contract between two parties (usually an investor and a financial intermediary) who agree to exchange financial flows with each other. Considered as a derivative, the Swap is therefore a financial product whose value is determined by the value of an underlying asset, liability, index or rate.
Two basic principles emerge from Canadian jurisprudence on the taxation of derivatives: first, in determining the nature of the income or loss arising from the use of a derivative, one must consider whether the derivative itself constitutes a hedging transaction with a sufficiently close link to the hedged transaction, in which case the hedged transaction must be referred to in determining the nature of the income. If not, the circumstances surrounding the derivative transaction in question must be taken into account, i.e. whether the transaction in question occurs in the course of the commercial activities of the taxpayer's business or is a speculative transaction, such as to constitutes an adventure or concern in the nature of trade, or whether it is an investment or gives the business an enduring advantage.
In our view, the income or capital character of a derivative can be determined by the character of an asset, liability or reference transaction (principal transaction) which may be different from the asset, liability or reference transaction used to determine the value of the derivative if the derivative is used for hedging purposes and the link between the derivative and the principal transaction is sufficiently close.
The principle of linkage in relation to a hedging transaction now appears to be entrenched in Canadian jurisprudence as a result of the Shell decision. In that case, which involved borrowings and a forward contract, it appears that at the time of the final payment on the forward contract, the New Zealand dollar had lost less than expected against the US dollar, resulting in a gain to Shell of US$21 million. The Supreme Court made the following statements regarding the character of the gain as income or capital gain:
"The purpose of the debenture purchase agreements was to provide Shell with working capital for a period of five years. It was a debt incurred on account of capital... Therefore, the foreign exchange gain arising from the fact that the value of the NZ$150 million that Shell returned to the foreign lenders in 1993 was less than the value of the NZ$150 million that Shell borrowed in 1988 was also received on capital account.
Whether a foreign exchange gain arising from a hedging contract should be characterized as being on income or capital account depends on the characterization of the debt obligation to which the hedge relates. As noted, Shell entered into the Forward Exchange Contract in order to hedge with US$ the market risk on the Debenture Agreements, which were denominated in NZ$. … The gain on the Debenture Agreements was characterized as being earned on capital account and so therefore should the gain on the Forward Exchange Contract. Both gains were earned on capital account and three-quarters of them are taxable when realized.
… As noted, the proper tax treatment of a foreign exchange gain on both the initial borrowing and any related hedge transaction is to be assessed in light of the characterization of the underlying debt obligation. …”
Shell shows that a close link must be present between the hedging transaction and the underlying obligation in order to establish the nature of the gain or loss from the hedging transaction.
We are of the view that the link between the Swap and the loan is sufficiently close to conclude as to there being a hedging transaction for the following reasons:
- The terms and conditions such as the duration, amount and maturity of the Swap match those of the credit granted;
- Although the Master Agreement indicates that the Swap transaction involves certain risks, the analysis of the contracts instead indicates that the Swap is a hedging transaction; in fact the taxpayer risks nothing but the future appreciation of those shares. Indeed, contrary to an interest rate Swap where the taxpayer risks losing the taxpayer’s stake, in the present case, the taxpayer has ensured, through the Swap transaction, receiving at the end of the transaction a value at least equal to the floor value of the shares at the time of the conclusion of the transaction. Not obtaining the potential future capital gain accumulated over XXXXXXXXXX years on the shares in question was irrelevant since the purpose of the transaction as a whole was to obtain the value of the shares subject to the Swap now without having to dispose of those assets for the specific purpose of immediately enjoying that value and without having to pay tax on the accrued capital gain on those assets at that time.
- The creation of the Swap is a precondition for the realization of the loan;
- The Swap matures at the same time as the loan agreement;
- It is not apparent from the facts of the case that the Taxpayer is engaged in any other derivatives trading activity; the Swap is not related to a business carried on by the Taxpayer.
- The termination of one of the two transactions necessarily results in the termination of the other;
- There is a legal relationship between each of the contracts analyzed for the purposes of this letter.
The value of the Corporation2 shares served as the basis for the Swap transaction, but this transaction was carried out in order to hedge the amount of credit granted by the Financial Institution to the Taxpayer. Furthermore, the contracts show that the value of the credit granted corresponds to the floor value of the Swap multiplied by the number of shares given as collateral for the loan. Furthermore, the Taxpayer was guaranteed to receive from the Financial Institution the floor value determined in the Swap agreement. Since the term of the Swap corresponded to the term of the loan, the Taxpayer was able to repay the borrowed money (which could not be higher than the floor value established in the Swap) with the amounts remitted by the Financial Institution at the termination of the Swap. The transaction was therefore not a speculative transaction and cannot be considered as an adventure in the nature of trade.
Consequently, we are of the view that the gain or loss arising from the payment at maturity of the Swap is of the same nature as the loan. If the loan is of a capital nature, as we have assumed, the gain or loss arising from the payment of the amount by the Taxpayer at the termination of the Swap which is the subject of this letter, will enjoy the same treatment. Thus, since the Taxpayer had to pay an amount to the Financial Institution as a consequence of the termination of the Swap, the loss suffered by the Taxpayer as a result of the payment of the Swap is of a capital nature.
A Swap contract constitutes a bundle of rights and obligations, and thus property for the purposes of the Act. Indeed, the definition of "property" in subsection 248(1) is broad enough to include contractual rights. It is then necessary to determine whether all or part of these rights and obligations are relinquished when the parties receive or pay an amount under the terms of the Swap in order to determine whether the receipt or payment of such an amount constitutes a capital gain or loss for the taxpayer concerned.
This position is based on the British judgments O'Brien v. Benson's Hosiery (Holdings) Ltd, [1979] STC 735 (HL) and Marten v. Inglis, [1980] STC 500 XXXXXXXX. In the second case, the taxpayer sold shares for a fixed amount immediately payable and another amount calculated according to a contingency formula. The gain on the disposition of the shares was calculated by reference to the fixed amount and the value, at the time of disposition, of the contingent right to receive deferred compensation. The right to this amount was characterized as an intangible right and, as such, a property of the taxpayer. When the right matured and the deferred amount was certain and payable, the taxpayer was considered to have made a disposition on receipt of money arising from the extinguishment or redemption of the right.
The following is an extract from that jurisprudence:
"...'Asset' is defined in 5. 22(1) in the widest terms to mean all forms of property, and it has been construed accordingly in O'Brien (Inspector of Tares) v. Benson's Hosiery Ltd. {1979} 3 All ER 652 at 655, {1980} AC 562 at 572 by Lord Russell. It is therefore apt to include the incorporeal right to money's worth which was a part of the consideration given for the share-holdings in 1970. The vendors could have disposed of the right at any time after 15th September 1970 by selling it or giving it away and assigning it. If they had done so, there would have been an actual disposal of an asset and the vendors would have been liable for capital gains tax on the amount, if any, by which the price or value of the asset at the date of disposal exceeded its value on 15th September 1970. Of course, if the price or value had been less than the value on 15th September 1970, they would have made a chargeable loss which they could have set off against gains in the same or future fiscal years. So there is nothing unfair in treating it as an asset. In fact, they did not dispose of the right but they held it until it matured on 5th December 1972. If the right was an `asset', then the sum which the vendors received on that date was `derived from' the asset. There was therefore, by virtue of s.22(3), a disposal of the asset notwithstanding +that no asset was acquired by the `person paying the capital sum', the purchaser. The sum was paid to satisfy or extinguish the right and not as any part of the consideration for the share- holdings; full consideration for them had already been given on 15th September 1970. The capital sum is therefore not in any relevant sense derived from the shareholdings, and the taxpayer's complaint that he was being assessed to capital gains tax twice over on the price is misconceived. The position is no different in principle from what it would have been if the vendors had received new shares in another company as part of the consideration for the shareholdings and had later disposed of the new shares."
In the case of an equity Swap where the rights of each party are extinguished at the end of the Swap, it is possible to apply the ratio of these UK judgments and assume that the payment of the amounts by the Taxpayer is the result of the surrender of its rights in the Swap contract.
In order to conclude that there is an allowable capital loss, the Taxpayer will have to show that the amounts paid constitute an expense incurred or made in order to realize the disposition of the intangible right that is the Swap.
Finally, as a subsidiary matter, we believe it is appropriate to advise you of the potential application of the general anti-avoidance rule in this type of transaction. As the transaction in question is statute-barred, an exhaustive analysis has not been carried out for the current purposes. However, we do not rule out the possibility of applying those provisions in similar monetization transactions. We are therefore of the view that transactions or series of transactions of the type described above could, depending on the facts and circumstances of the particular situation, engage the application of subsection 245(2).
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
Best regards,
Ghislain Martineau
Section Manager
Financing and Plans Section
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch
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